The Hindu Business Line : Open with caution

IN A MOVE expected to further open up the commodity futures market and allow large investments to flow into what was not long ago unglamorously staid business — commodity derivatives trading — the Forward Markets Commission (FMC) has decided to allow mutual funds and foreign institutional investors to participate in bullion and crude oil futures at the national commodity exchanges. The announcement comes even as the debate over who should regulate the MFs and the FIIs entering commodity derivatives trading is far from settled.

For nearly two years, the Securities and Exchange Board of India has been sitting on applications from the MFs to allow investments in gold. Now, the FMC wants SEBI to amend the law so that MFs and FIIs can participate in commodity futures. Vis-à-vis derivatives, it makes both regulatory and business sense for the FMC to oversee the MFs and the FIIs because the `underlying' asset would be a commodity. The FMC's caution in opening the sluice valves of funds by limiting institutional participation to just three non-agricultural commodities is justified. The interest in these commodities is largely speculative and the role of hedgers quite limited. A larger flow of money into these commodities may fill the liquidity gap, but could raise price volatility.

The involvement of the MFs would no doubt encourage small investors to come into the commodity derivatives space, but do the MFs have the expertise to invest in and benefit from price movements of highly volatile commodities such as bullion and crude oil? They need to build strong research and commercial intelligence desks to be able to deliver real value to their investors. Despite being the largest importer of gold, India is a `price taker' and not a setter in the world market and the country has only a secondary impact on the global gold prices. India is unlikely to become a price setter anytime soon because several — structural, regulatory, infrastructure — issues need to be sorted out. Contrary to what the FMC chairman believes, it is premature to expect India to become a gold price setter by allowing the MFs to participate in futures trading. A worrisome aspect of the FMC chief's statement is the impending recommendation to allow commercial banks to enter commodity derivatives. Caution is necessary.

It appears everyone concerned with policy formulation is under pressure to ensure higher trading volumes at the exchanges by allowing larger flow of funds. It would be too risky to allow too much cheap money to chase commodities too soon. A lot more restraint is necessary in allowing banks to trade derivatives, given the sensitivities and the limitations of both the physical and the futures commodity market which is quite unlike the equity segment. Policy-makers have to learn from the latest gold story — its high international prices are unrelated to demand-supply fundamentals and are driven by non-fundamental issues, including huge speculative interest. It could turn out to be disastrous for our frail and nascent commodity markets to handle unlimited flow of funds. Too much money flow is unlikely to benefit anyone other than speculators.